U.S. Disfavor Drains Turkish Economy

By LANDON THOMAS Jr.

Published: March 25, 2003

Correction Appended

When Turkey and the United States failed to finalize a deal last week to send ground forces through Turkey into Iraq, American war planners were inconvenienced, but the Turkish financial markets were devastated.

The Istanbul Stock Exchange has fallen by a quarter from its February high and is approaching an all-time low. The country's benchmark eurobonds are trading at 87.82 cents on the dollar, down 19 percent in a week. Rumors are swirling that the government is nearing default on its domestic debt.

Investing in Turkey has always been a roller coaster ride. The realities of high inflation rates, yawning budget deficits and impenetrable politics have been mitigated, at times, by rapid economic growth and a roster of globally competitive companies.

Seasoned emerging-market investors have generally been willing to stomach the ride because of a belief that no matter how bad things became, Turkey would never be allowed to fail: the United States would always come to the rescue of so important a strategic ally.

But when the Turkish Parliament rejected the proposal by the ruling Justice and Development Party to accept American ground troops in return for $30 billion in guaranteed credits, that faith was deeply dented.

The possibility that the United States would walk away from Turkey was suddenly a nightmare to consider. ''I think relations between the U.S and Turkey have been harmed tremendously,'' said Mehmet Kutman, the chairman of Global Securities, one of Turkey's larger brokerage houses. ''People have lost their confidence, and unless some new money comes in, Turkey could well announce a moratorium on its domestic debt.''

During a three-week span in November, foreign investors injected over $2 billion into the Turkish markets on the assumption that the newly elected Justice and Development Party would be in a strong position to negotiate aid from the United States as part of a deal on Iraq.

The Istanbul Stock Exchange shot up on the prospect of billions of dollars in cheap foreign credits being made available to Turkey and the expectation that more private money would follow. Underpinning the optimism was the sense that Turkey's status as America's chief strategic partner in the region would attract even more bounty in the future, like fresh credits from the International Monetary Fund and perhaps even entry into the European Union.

Yes, many investors reasoned, there were short-term risks, including economic harm from the war, but the long-term benefits would be great.

This enthusiasm overlooked what proved to be a crucial factor: Turkey's new government had the largest parliamentary majority in years, but the ruling party itself was something of a paper tiger, a recently assembled collection of conservative Islamist politicians that had never governed in Turkey and had virtually no experience on the world stage.

It did not even start with a genuine prime minister. Tayyip Erdogan, the leader of the party, had been barred from holding public office, a ban that has since been lifted.

As a result, the new government proved unable to push the deal with the United States through the fractious Turkish Parliament, and was left looking ineffectual both domestically and internationally.

Mr. Erdogan is now the prime minister, but with hostilities underway in Iraq, and Turkey mainly on the sidelines, he heads a government in disarray. It has infuriated two powerful constituencies, the Bush administration and the ultimate arbiter of Turkish politics, the country's powerful military.

After the 1991 Gulf war, the Turkish economy fell immediately into a recession, but it kept the good will of the United States because of the unflinching support that Turgut Ozal, Turkey's prime minister at the time, showed for the campaign to oust Iraqi invaders from Kuwait.

Now, at least for the moment, that good will has evaporated. And with the Turkish military eager to send its troops into northern Iraq, Turkish and United States interests are now more at odds than converging.

''The basis of the Turkish-American relationship was always strategic, not geographic or cultural,'' said Bulent Aliriza, a Turkey analyst at the Center for Strategic and International Studies in Washington. ''That was fine and dandy during the cold war. Now, if you take strategy out of the relationship, there is nothing left except the verdict of the market.''

That verdict has been a harsh one. With the erosion of the ''strategic premium'' on Turkish financial assets, the spread between Turkish bonds and United States Treasury bonds has widened to 10 percentage points, and Turkish domestic interest rates have soared.

With no new flood of aid from the United States and with the international debt markets unfriendly as well, Turkey has no way to finance its budget deficit -- largely created by interest costs on borrowings -- other than to try to borrow again from the tapped-out domestic debt market. Foreign investors have pulled out of this market, Turkish brokers say.

''Due to inflation-adjusted interest rates of 35 percent, the debt-to-gross domestic-product ratio will increase,'' said Berna Bayazitoglu, an economist at Credit Suisse First Boston in Istanbul. ''If rates continue at these levels, the ratings agencies might downgrade Turkish debt.''

The combination of a domestic default and a possible run on the currency could lead to a broader financial collapse, analysts say.

The Turkish government is in talks with the International Monetary Fund for an infusion of cash that it badly needs. To get the money, the government must meet certain fiscal goals. Analysts in Turkey expect them to be met this year, but big questions loom, especially taking into account the cost of stepped up military operations on the Iraq border and, perhaps, beyond it.

Meanwhile, Turkey is down to the last $3.5 billion in credits under the existing agreement with the monetary fund, making it look vulnerable to a speculative run unless a new deal is struck.

As the largest investor in the fund, the United States has historically been a supportive voice for Turkey. How enthusiastic the Bush administration will be now remains a question mark, analysts say.

If the Turkish financial markets were to implode, other emerging and developed markets would be only minimally affected, investors say. Unlike Mexico in 1994, Thailand in 1997, or Russia in 1998, Turkey now has relatively little exposure to foreign investors.

More important are the geopolitical consequences. While there are few signs yet in Turkey of Argentina-style social upheaval, analysts do not discount the possibility of social tensions boiling over in the coming months.

''If winning the war in Iraq sends Turkey into a spiral, that is a huge price to pay for overthrowing the regime in Baghdad,'' said Philip Gordon, a Turkey expert and a senior fellow at the Brookings Institution.

Photo: A girl buys bread yesterday in Adana, in southern Turkey. So far, there have been few signs of social upheaval in the country, even as the Istanbul Stock Exchange and other economic indexes have been reeling. (Reuters) Graph: ''Shattered Optimism'' Since an aid-for-access deal between the United States and Turkey failed to win approval in the Turkish Parliament, investors have sold Turkish stocks and bonds heavily. Graph tracks Istanbul stock exchange, national 100 index and yield on dollar-denominated government bonds due in 2030 since October 2002. (Source: Bloomberg Financial Markets)

Correction: April 3, 2003, Thursday An article in World Business on March 25 about the effect of United States relations on the Turkish economy gave an incomplete summary of the views of Mehmet Kutman, chairman of a large brokerage house, on the future of the nation's domestic debt. While he discussed several possible outcomes, including a moratorium on payments, he said that a debt swap or voluntary restructuring, similar to one in June 2001, was more likely.